Developing a Call Action Plan

Earning a consistently high yield from writing calls is not always possible, even for covered call writers. In addition to picking the right options at the right time, a covered strategy has to be structured around well-selected stocks, preferably those that have appreciated since purchase. In addition, even with the right stocks in your portfolio, you might need to wait out the market. Timing refers not only to the richness of option premiums, but also to the tendencies in the stock and in the market as a whole.

You could be able to sell a call rich in time value and profit from the combination of capital gains, dividends, and call premium. But the opportunity is not always going to be available, depending on a combination of factors:

The price of the underlying stock has to be at the right level in two respects. First, the relationship between current market value and your basis in the stock has to justify the exposure to exercise, to ensure that in the event of exercise, you will have a profit and not a loss. If this is not possible, then there is no justification in writing the call. Second, the current market value of the underlying stock also has to be correct in relation to the striking price of the call. Otherwise, the time value will not be high enough to justify the transaction.

The volume of investor interest in the stock and related options has to be high enough to provide adequate time value to build in a profit.

The time between the point of sale of a call and expiration should fit with your personal goals. As with all other investment decisions, no strategy is appropriate unless it represents an intelligent fit.

In evaluating various strategies you could employ as a call writer, avoid the mistake of assuming that today's market conditions are permanent. Markets change constantly, resulting in unpredictable stock price levels. The ideal call write will be undertaken when the following conditions are present:

The striking price of the option is higher than your original basis in the stock. Thus, exercise would produce a profit both in the stock and in the option. If the striking price of the option is lower than your basis in the stock, the option premium should be higher than the difference, while also covering transaction fees in both stock and option trades.

The call is in the money, but not deep in the money. This means it will contain a degree of intrinsic value, so stock movements will be paralleled with dollar-for-dollar price changes in option premium, maximizing the opportunity to close the call at a profit with relatively minor stock price movement.

The call is out of the money, but not deep out of the money. In this situation, all of the premium represents time value. As long as the stock's market value stays at or below the call's striking price, it will expire worthless. In the alternative, you can wait for time value to decline enough to close out the position at a profit.

There is enough time remaining until expiration that most of the premium is time value. Even with minimal or no price movement in the stock, time value evaporates by expiration. As an option writer, you are compensated by being exposed to risk for a longer period, through higher time value.

Expiration will occur in six months or less. You might not want to be locked in to a striking price for too long, and the identification of six months as a cutoff is arbitrary. The point is, the longer the time until expiration, the higher the time value; and that time value tends to fall most rapidly during the last two to three months. As an alternative, you can employ longer-term long-term equity anticipation security (LEAPS) options, accepting the extended exposure for higher time value premium.

Premium is high enough to justify the risk. You will be locked in until expiration unless you later close the short option position with an offsetting purchase. In that sense, you risk price increases in the underlying stock and corresponding lost opportunity.

Example

Ideal Circumstances: You own 100 shares of stock that you bought at $53 per share. Current market value is $57. You write a 55 call with five months to go until expiration that has a premium of 6. The circumstances are ideal. Striking price is 2 points higher than your basis in the stock; the call is two points in the money, so that the options premium value will be responsive to price changes in the stock; two-thirds of current option premium is time value; expiration takes place in less than six months; and the premium is $600, a rich level considering your basis in the stock. It is equal to 11.3 percent of your original stock investment, an exceptional return ($600 Ã· $5,300).

In this example, you would earn a substantial return whether the option is exercised or expires worthless. If the stock's market value falls, the $600 call premium provides significant downside protection, discounting your basis to $47 per share. A worst-case analysis shows that if the stock's market value fell to $47 per share and the option then expired worthless, the net result would be breakeven.

By Michael C. Thomsett

Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.